Thursday, January 04, 2007

David Wessel has a nice summary of the problem the Fed faces of determining
policy in the next few years given the uncertainty about the long-run
sustainable growth rate for the economy. Is 3% the natural rate of output
growth? Is it 2.5%? As noted, the answer matters both for what growth rate the Fed will
allow the economy to actually achieve -- over a number of years the difference
between 2.5% growth and 3% growth is large -- and for how the Fed will react to things like increases in wages. For example, if the Fed believes the natural
rate is 2.5% and it projects a 2.75% growth rate going forward, it will worry about
inflation and slow the economy. This puts downward pressure on wages and
employment. But if the Fed believes the sustainable rate is 3%, it would welcome
more robust employment growth:

"Safe," in the minds of central bankers, is the pace at which an economy can
expand without generating rising inflation. [If] Central bankers ... [s]et rates
too low, ... demand can exceed supply and push up prices. Set rates too high,
and a glut of unused capacity will yield higher unemployment and lower
inflation, perhaps even falling prices.

Today, Fed officials are relieved that the economy has been slower than what
is sometimes called "trend" or "potential." They wanted slower growth to avoid
an outbreak of inflation. But a big question is what speed limit the Fed should
anticipate for the rest of this decade. Lately, Fed officials have been
speculating that the safe growth rate for the U.S. economy in the future may be
slightly slower than the 3% annual growth rate of the past five years.

It is easy to cast this as an academic, number-clogged debate. In fact, it is
an instance where what the Fed thinks matters to all of us, not just bond
traders. The Fed's estimate for trend growth determines whether officials will
let the economy expand at, say, 3% on average, or just 2.75%. The difference
sounds small, but adds up over time. An extra one-quarter percentage point in
annual growth would mean $130 billion more goods and services for Americans to
share by 2026.

An economy's speed limit is largely defined by two factors: how rapidly the
number of workers increases and their "productivity," or how much each of them
produces.

The Fed doesn't disclose its precise projection for the safe speed limit. A
public summary of Fed officials' October meeting noted that "the staff...had
again reduced its projection for potential...growth." ... Growth is slowing, and
the phenomenon isn't temporary. The aging of the big baby-boom generation is
bringing it to the brink of retirement, and the proportion of women who work
seems to have peaked.

Nothing is certain here. Improved health and longevity or skimpier pensions
may keep baby boomers working longer. Technology may reduce employers' demand
for labor. Immigration could increase. ... Fed board member Susan Bies has noted
that a 0.2-percentage-point slowdown in labor-force growth means it takes fewer
new jobs to keep the nation's unemployment rate steady -- 110,000 jobs a month,
instead of 140,000 a month.

Productivity is particularly tough to forecast. ...[T]here are some signs
that productivity growth may be slowing a bit from the pace of the early 2000s.
... The just-released minutes of the Fed's December meeting record concern that
the underlying pace of productivity growth "could be weaker than currently
thought." ...

The Fed can't turn the dials on population growth or on productivity. All it
can do is try to gauge trends accurately. Continued strong productivity growth
will lead the Fed to tolerate faster economic growth. That puts the onus on the
rest of the society -- business, unions, workers, regulators, legislators,
schools -- to work at doing what is possible to maintain healthy productivity
growth, the secret to prosperity for our children and grandchildren.

I think it's fair to wonder if the experience of the 1970s has made the Fed
overly cautious with respect to inflation and hence more likely to target too
low a growth rate than one that is too high (affecting employment and wages).

Because there have only been a limited number of cyclic episodes since
the Fed adopted its current operating procedure, each episode adds a lot to the
Fed's knowledge of how to react to shocks of various types. The current episode
will help to determine how the Fed behaves in the future. If inflation and
inflationary expectations drift upward in coming months while the economy
remains relatively healthy, the hawks will gain credibility. If there is a
hard-landing, the doves will have the "I told you so" upper-hand. And of
course, if sustainable growth with reasonable inflation is the
outcome, the Fed will pat itself on the back and believe it handled things just
right.

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What Output Growth Rate Should the Fed Target?

David Wessel has a nice summary of the problem the Fed faces of determining
policy in the next few years given the uncertainty about the long-run
sustainable growth rate for the economy. Is 3% the natural rate of output
growth? Is it 2.5%? As noted, the answer matters both for what growth rate the Fed will
allow the economy to actually achieve -- over a number of years the difference
between 2.5% growth and 3% growth is large -- and for how the Fed will react to things like increases in wages. For example, if the Fed believes the natural
rate is 2.5% and it projects a 2.75% growth rate going forward, it will worry about
inflation and slow the economy. This puts downward pressure on wages and
employment. But if the Fed believes the sustainable rate is 3%, it would welcome
more robust employment growth:

"Safe," in the minds of central bankers, is the pace at which an economy can
expand without generating rising inflation. [If] Central bankers ... [s]et rates
too low, ... demand can exceed supply and push up prices. Set rates too high,
and a glut of unused capacity will yield higher unemployment and lower
inflation, perhaps even falling prices.

Today, Fed officials are relieved that the economy has been slower than what
is sometimes called "trend" or "potential." They wanted slower growth to avoid
an outbreak of inflation. But a big question is what speed limit the Fed should
anticipate for the rest of this decade. Lately, Fed officials have been
speculating that the safe growth rate for the U.S. economy in the future may be
slightly slower than the 3% annual growth rate of the past five years.

It is easy to cast this as an academic, number-clogged debate. In fact, it is
an instance where what the Fed thinks matters to all of us, not just bond
traders. The Fed's estimate for trend growth determines whether officials will
let the economy expand at, say, 3% on average, or just 2.75%. The difference
sounds small, but adds up over time. An extra one-quarter percentage point in
annual growth would mean $130 billion more goods and services for Americans to
share by 2026.

An economy's speed limit is largely defined by two factors: how rapidly the
number of workers increases and their "productivity," or how much each of them
produces.

The Fed doesn't disclose its precise projection for the safe speed limit. A
public summary of Fed officials' October meeting noted that "the staff...had
again reduced its projection for potential...growth." ... Growth is slowing, and
the phenomenon isn't temporary. The aging of the big baby-boom generation is
bringing it to the brink of retirement, and the proportion of women who work
seems to have peaked.

Nothing is certain here. Improved health and longevity or skimpier pensions
may keep baby boomers working longer. Technology may reduce employers' demand
for labor. Immigration could increase. ... Fed board member Susan Bies has noted
that a 0.2-percentage-point slowdown in labor-force growth means it takes fewer
new jobs to keep the nation's unemployment rate steady -- 110,000 jobs a month,
instead of 140,000 a month.

Productivity is particularly tough to forecast. ...[T]here are some signs
that productivity growth may be slowing a bit from the pace of the early 2000s.
... The just-released minutes of the Fed's December meeting record concern that
the underlying pace of productivity growth "could be weaker than currently
thought." ...

The Fed can't turn the dials on population growth or on productivity. All it
can do is try to gauge trends accurately. Continued strong productivity growth
will lead the Fed to tolerate faster economic growth. That puts the onus on the
rest of the society -- business, unions, workers, regulators, legislators,
schools -- to work at doing what is possible to maintain healthy productivity
growth, the secret to prosperity for our children and grandchildren.

I think it's fair to wonder if the experience of the 1970s has made the Fed
overly cautious with respect to inflation and hence more likely to target too
low a growth rate than one that is too high (affecting employment and wages).

Because there have only been a limited number of cyclic episodes since
the Fed adopted its current operating procedure, each episode adds a lot to the
Fed's knowledge of how to react to shocks of various types. The current episode
will help to determine how the Fed behaves in the future. If inflation and
inflationary expectations drift upward in coming months while the economy
remains relatively healthy, the hawks will gain credibility. If there is a
hard-landing, the doves will have the "I told you so" upper-hand. And of
course, if sustainable growth with reasonable inflation is the
outcome, the Fed will pat itself on the back and believe it handled things just
right.